Ch 5&6

Cost-Benefit Analysis

• The role of a financial manager is to make decisions on behalf of the firm's investors, ensuring that the benefits of a decision exceed the costs.
• Real-world opportunities often involve multiple disciplines, including marketing, economics, organizational behavior, strategy, and operations.
• A decision will increase the value of the firm if the value of the benefits exceeds the costs.

Market Prices and the Valuation Principle

• In a competitive market, the price determines the value of a good, and personal opinions of the "fair" price are irrelevant.
• The Valuation Principle states that the value of an asset or commodity to the firm or its investors is determined by its competitive market price.
• The benefits and costs of a decision should be evaluated using market prices.
• If the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.
• Current prices in a competitive market are the only relevant prices when evaluating a decision.

The Law of One Price and Arbitrage

• The Law of One Price states that securities with the same cash flows must have the same price in competitive markets.
• Arbitrage is the method of buying something in one place and selling it in another place at the same time to make a profit from the price difference.
• An arbitrage opportunity is a situation where it is possible to make a profit without taking any risk or making any investment.

The Time Value of Money and Interest Rates

• A dollar today is worth more than a dollar in one year due to the time value of money.
• The time value of money is the difference in value between money today and money in the future.
• If you deposit $1 at a 10% interest rate, you will have $1.10 at the end of one year.

Enterprise Risk Management

• Ultimate objective is to handle risks harmonious with the strategic plan
• Making pre-loss arrangements for post-loss resources
• Need for loss identification and risk identification

Employment

• Staff varies based on size and responsibility
• All firms and people engage in risk management
• Career opportunities internally to firms and externally, like consultants and brokers
• Occupation is professionally recognized – RIMS – Risk and Insurance Management Society

Useful Methods

• Identify & Measure (evaluate)
• Choose most efficient tool(s) for Control
• Implement and review

Risk Identification

• Identify how and what to identify:
• Balance sheet
• External/Internal
• Income statement
• Pure/Speculative
• Other records
• Direct losses
• Indirect losses
• Key personnel
• Operations
• Checklists
• Flow charts
• Questionnaires

Measure (Evaluation)

• Maximum possible loss: the absolute maximum dollar amount of damage
• Maximum probable loss: a conservative estimate of what is likely to occur in a worst case loss
• Relative Frequency: an estimate as to the number of times the loss will occur

Property Risks

• Tangible Property:
• Real Property
• Business Property
• Intangible Property:
• Patents
• Human Capital
• R&D
• Reputation
• Brand Awareness

Property Risks

• Damage to the Property of Others:
• Supply chains are interconnected
• Disruption or outright failure can occur at a firm
• Affecting other firms in supply chain

Valuing Property

• Replacement value versus book value versus actual cash value versus market value
• Book value: net value of a firm's assets found on its balance sheet
• Market value: company's worth based on the total value of its outstanding shares in the market
• Replacement value: amount of money that could be obtained by replacing the existing asset

Liability Legal Grounds

• American legal system based on the notion that a person should be responsible for the damage caused to others
• Negligence:
• Failing to use reasonable care according to a “reasonable man” standard
• A reasonable person thinks before speaking or acting, and is honest and moderate in all activities
• Question of fact
• Other parties can be held liable:
  • Vicarious liability
  • Joint-and-several liability

Establishing Negligence

• Plaintiff must show:
• Legal duty
• Failure of the duty
• Injury
• Causal connection between the injury and the failure
• Jury must weigh the facts based upon “the preponderance of evidence”

Types of Damages

• Compensation for Personal Injuries:
• Medical
• Lost wages
• Future wage loss
• Pain and suffering
• Punitive Damages:
• Compensation to punish a defendant for outrageous acts
• Punitive damages against insurers:
• When insurers act in bad faith in resisting an insured’s legitimate claim
• Other Damages:
• Hedonic damages - loss of life’s pleasures
• Mental anguish

Human Resource Risks

• Loss of Key Person
• Disability – physical (medical) or mental
• Loss of health
• Unplanned retirement
• Results in loss of income, business continuation problems, replacement and training issues

Review and Update

• Regularly review and update the process:
• New assets or disposal of assets
• Valuation changes
• New products, processes, and operations
• New personnel
• Law changes
• Currency fluctuations
• New contractual relationships

Learn about the role of a financial manager in making decisions that maximize benefits while minimizing costs and understand the concept of market prices and valuation principle.